How to identify and trade market sentiment, from risk-on to risk-off

The term “market flows” is quite common, but the concept may sound vague. Let’s go over what market flows are and how to identify them.

Market flows are the “money movements" that drive financial markets. They look at where the mass of money was at a given period and where it is currently heading with the constant new flow of information.

The mass of different participants will move financial markets depending on many factors, including geopolitical, economic, investment cycles, and other elements.

Flows are complex and constantly changing.

However, you may picture them as watching traffic patterns on a highway — you can see which direction has more volume and, depending on the ongoing dynamics, where they could be heading.

Essentially, market flows indicate where money is going, why it’s moving, and what it might mean for future price action. They’re a key driver behind price trends and volatility, beyond fundamentals or technicals.

The key insight is that market flows often lead price movements, so traders who can read these patterns get early signals about the market direction.

It’s beneficial for understanding institutional behaviour versus retail investor sentiment, and even more so, whether flows are leaning more towards risk assets (risk-on flows) or safe havens (risk-off flows).

Risk-on flows occur when positive investor sentiment shifts capital flows towards risk assets. This phenomenon usually correlates with increased confidence in economic growth, corporate earnings, and overall market stability.

Risk-on environments typically emerge from positive economic data, dovish central bank policies, geopolitical stability, or strong corporate earnings.

The ongoing uptrend in stock indices reflects such themes as the ongoing earnings season, which has not disappointed equity markets.

There is also a theme since 2024 with equities evolving around the AI theme, which is both a disinflationary and growth-generating revolution.

Investors become more willing to invest in growth and higher-yielding assets, leaving safety and defensive assets for potentially more lucrative opportunities.

Equity indices tend to lead during risk-on flows, as investors grow optimistic about the economic outlook and the potential for future returns across both large and small-cap companies.

In Forex, there is an informal sub-category of "risk-on currencies." These are typically tied to more cyclical economies — nations that benefit from increased global trade and improved economic projections.

Commodity-exporting countries such as Canada (CAD), Australia (AUD), and New Zealand (NZD) tend to see stronger growth prospects when global sentiment improves and demand for raw materials increases.
Investors would also borrow from lower-yielding currencies and invest in these higher-yielding currencies in what is famously named “carry trades”¹, further boosting their demand in risk-on sentiment.

Commodities like oil, copper, and silver also tend to perform well under such conditions, further supporting these currencies.

It’s important to note that forex demand doesn’t rely solely on sentiment. Other drivers, such as interest rate differentials, central bank expectations, and capital flow dynamics also play a significant role in determining currency strength even if sentiment is strictly positive.

Safe-haven assets tend to see more demand during risk-off sessions.

This more specific form of market sentiment usually builds during times of market stress. It’s usually linked to geopolitical turmoil, streams of worsening economic data, negative Black Swans (like terrorist attacks or bank failures), and a restrictive policy stance.

Risk-off markets typically see flows coming in suddenly due to the more imminent nature of market-shaking events and tend to be difficult to predict.

They are likely to correlate with lower performance of equities and, more typically, risk-on assets as investors see a worsening economic outlook and confidence.

The concept of safe-haven assets comes from their perceived reliability, strong government backing (for example, with US Treasuries), and their historic performance in volatile, crisis periods.

However, not all safe havens behave the same way in every environment. Factors like inflation, central bank policy, or relative interest rates can shift what investors consider safe.

In short, safe-havens offer psychological reassurance and portfolio protection when fear takes control.

Gold and government bonds are historically considered safe havens, due to their historically strong performance in times of turmoil.² Their status can fluctuate depending on market-specific economic data or geopolitical conditions. Although sometimes temporary, these assets see sudden spikes in demand as market stress materialises.

Stock markets also have risk-off flows, where investors tend to flee higher beta sectors (such as technology stocks, for example) towards more consumer defensive stocks (Blue Chips, traditionally consumer-oriented).

In Forex, in addition to traditional “risk-on currencies,” there are also “risk-off currencies,” which are most commonly the Swiss franc, Japanese yen, and US dollar.

Except for the USD, which sees more complex flows due to its reserve currency status, reasons for flows going towards the CHF and JPY are, for example, the unwinding of carry trades. This is because relative interest rates tend to decline in other cyclical economies and their stable external policies, as Japan and Switzerland rarely enter into conflicts.

It is a million-dollar question that market participants try to answer at all times in the movement of financial flows.

It’s as complex as the number of possibilities and the changing nature of markets as circumstances will shift depending on what the ongoing theme is and how positioning is already set.

However, there are some general ideas to help traders position themselves in the ongoing session:

• Creating watchlists to spot what asset classes are being bought and sold, something available on most charting platforms like TradingView.
• Monitoring the latest headlines could also help you to assess whether there is ongoing market fear or if markets are trading as usual.
• Using volatility tools, like the VIX (Volatility of Equity Options) or the MOVE (Volatility of US Treasury Bond options), to monitor the markets where any sudden spikes could mean a move towards safety.

Identifying the current market flows is a crucial practice for most seasoned traders.

By establishing a consistent process to determine whether you are in a risk-on, risk-off, or neutral session, you can position yourself to capitalise on trades that are more likely to yield positive outcomes.

This approach not only aids in recognising where the market momentum lies, but also helps in making informed decisions about entering or exiting trades based on prevailing market conditions.

Understanding these dynamics might significantly enhance your trading strategy and improve your overall results.

Footnotes:

¹ https://www.investopedia.com/carry-trade-definition-4682656

² https://sprott.com/investment-strategies/exchange-listed-products/physical-bullion-funds/the-case-for-gold-in-crises/